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CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
Earnings quality and the quality of financial reporting in general are subjects
that have attracted much attention and are the centre of debate for investors,
regulators as well as scholars in the recent years. This heightened attention to the
subject of earnings quality is, in part, due to the wave of accounting scandals of the
early 2000s (the manipulation of accounting figures) (Hermanns, 2006). However,
earnings quality has been a topic of increasing importance and interest especially
after the colossal corporate collapses of Enron, WorldCom, Parmalat and, more
specifically, Leisurenet and Fidentia in South Africa amongst others, which has put
a big question mark on the financial reporting quality of the publicly listed
companies in stock market (Abdullah, 2004).
Earnings quality is of interest to users of financial statements because
earnings and the varied metrics derived there from are utilized in making
contracting and investment decisions. From a contracting perspective, low-quality
earnings may result in unintended wealth transfers. From an investor‟s vantage
point, low-quality earnings are undesirable because they result in a defective
resource allocation signal (Schipper & Vincent, 2003). This is also supported by
Myers, Myers & Omer (2003), who stated that poor quality of earnings is
problematic because it can mislead investors, resulting in misallocation of
resources. In the recent work of Redhwan, (2014) erosions in earnings quality,
transparency, and disclosure levels have caused investors to be less confident in the
integrity of accounting numbers. Since investors need unbiased earnings
information to make the right investment decisions, financial crises and financial
reporting scandals have unveiled the importance of board supervision and
highlighted the crucial need for firms to enhance the quality of reported earnings.
Earnings quality is an important characteristic of financial reports that affects the
efficient allocation of resources (Peter, Baruch, Melissa, & Sarah , 2013).
The generation of quality earnings information depends on a whole set of
guarantee mechanisms, for instance, a governance mechanism capable of
efficiently supervising the process of accounting information reporting. The board
of directors, as the core of corporate governance, will undoubtedly play a key role
in supervising listed companies‟ financial reporting process and the quality of
financial reporting. Strengthening the board of directors, such as enhancing the
board‟s independence, improving its capabilities of detecting problems in financial
statements, and clarifying explicitly directors‟ responsibilities, is regarded as an
efficient way to ameliorate the board supervisory and monitoring practices and the
quality of financial reporting (Qinghua, Pingxin & Junming, 2007).
Accounting scandals broke out one after another in various enterprises,
under the guise of related party transactions, and accounting fraud was perpetrated
through benefit transactions between the parent and subsidiary companies, such as
Enron and WorldCom in the United States. The occurrence of these major cases
exposed the lack of supervising mechanisms in enterprise management and
resulted in heavy investor losses. In order to reduce the behavior of surplus
manipulation of enterprises and to restore investor confidence and stable
operations in the capital markets, the Organization for Economic Cooperation and
Development (OECD), the World Bank, and other international organizations
advocated supervising mechanisms to strengthen corporate governance effectively.
Therefore, the related issue of supervising mechanisms that could enhance the
effectiveness of corporate governance gained momentum and received
considerable attention in countries around the world, and became an important
topic of academic research (Hsiang-tsai, .Li-jen, & Chih-Hung, 2012).
According to Qing, Yuning & Besim-Burcin (2013) When the Management
rights and ownership is separated, the prevailing view is that the important function
of the board is supervision on behalf of shareholders. The management of a
company should be monitored by the board of directors on behalf of the
shareholders. Managers should be accountable to the board, which, in turn, should
be accountable to the shareholders, whose task it is to appoint the board of
directors (Abor & Adjasi 2007 and Maharaj 2009). To fulfill its monitoring and
supervisory role, board members need sufficient expertise and firm specific
knowledge. Accounting literature discusses various board characteristics that
influence the demand for and characteristics of financial reporting (Nina, 2011).
Therefore, there might be a relationship between earnings quality and board
supervision to a large extent.
The concept of earnings quality has attracted various definitions over time.
The accounting literatures embrace several definitions of earnings quality. Some
related to the persistence of earnings others relate to the accurate representation of
underlying economic transactions and events. Still other authors consider the
relation between accruals and cash flows. Francis et al. (2004) identify seven
measures of earnings quality which they characterize as either “accounting-based”
or “market-based” depending on the underlying assumptions about the function of
financial reporting, and they noted that these assumptions will, in turn, influence
the way the attributes are measured. Accounting-based earnings quality measures
assume that the function of earnings is to allocate cash flows to reporting periods
via accruals, while market-based earnings quality measures assume that the
function of earnings is to reflect economic income as represented by stock returns.
While one should anticipate that better board supervision leads to improve earnings
quality, there is lack of agreement as to how quality of earnings can be measured
(Tabitha, Eunice, & Olaroyeke, 2014).
Mohamed & Aiman (2013) stated that board size is shown as a significant
part of the ability of boards to effectively monitor management and to work
efficiently together to oversee the running of the business. Board size is an
indicator of both its monitoring and advisory roles, both of which may contribute
to its oversight into management behavior (Coles, Daniel, & Naveen, 2008).
Recently, Redhwan & Ku-Nor (2014) stated that board size is an important
element that impacts the effectiveness of board oversight duties. Board size is used
as an instrument for two reasons. Firstly, the fraction of independent directors is
likely to be smaller for boards with more members (Chen & Al-Najjar 2012).
Secondly, firms with larger boards presumably can afford to invite outside
directors to their boards without sacrificing representation of the insiders (Agrawal
& Knoeber 1996). Several studies use board size as a measure of board quality
(Yermack 1996; Cyert et al. 2002; Weber 2006). Larger boards are viewed as
having expert board members, especially those who are independent and can
provide environmental links (Redhwan , 2014) which may lead to effective
supervision and higher earnings quality.
To be effective, the Cadbury Report (1992), for example, recommends the
board to be comprised of majority of non-executive directors who are likely to
bring an independent judgment. Non-executive directors effectively monitor firm
activities; reduce agency costs; and, hence, improve earnings quality (Fama &
Jensen 1983; Jensen & Meckling 1976). Consistent with these assertions, empirical
studies conclude that reported earnings quality is enhanced as the proportion of
non-executive directors increases (Dimitropoulos & Asteriou 2010 and Sahlan
2011). Another board supervision attributes that has been identified as being
relevant to financial reporting is frequency of meeting. Xie, Davidson, & DaDalt,
(2003) found a positive relation between board meeting frequency and earnings
quality,
Corporate governance refers to the supervision of companies by board of
directors and supervisors, the perfection of the shareholding structure, and the
enhancement of information transparency (Chiang, 2011). It is one of the most
important duties of the board supervision and according to Low, Law, & Ong;
(2011) corporate governance to ensure the quality of financial reporting. Sytse &
Hein (2013) in their study indicated that corporate governance control mechanisms
are designed to reduce the inefficiencies, an ideal monitoring and control system
should regulate both motivation and ability, while providing incentive alignment
toward corporate goals and objectives. Therefore, board supervision has linkage
with corporate governance.
Each person who reads or hears the word „supervision‟ interprets it in terms
of his past experiences, his needs and his purpose. Supervision means to be in
charge of somebody or something and make sure that everything is done correctly,
safely and according to the purpose or goals it intends to achieve. The purpose of
supervision is to enhance justice, increase transparency, raise accountability,
decrease conflict of agency, reduce information asymmetry, better performance,
increase corporate value and better the status of shareholders. The board of
directors has an important role in overseeing how management serves the long
term interests of shareowners and other stakeholders, as well as overseeing the
duties of the inside and outside directors (Yi-Hsien, Chung-chu & Shu-yu, 2010).
Generally, a conglomerate is a large company that consists of diverse
divisions that produce and sell unrelated goods and services. The Nigerian
conglomerate sector comprises of multinational companies engaged in multifaceted services ranging from manufacturing and sales of foods and personal care
products, sales and distribution of automobiles and equipments. The companies
under the sector can be largely divided into two, based on their major areas of
focus. The first group is involved mainly in the manufacturing of foods and house
care items and the other group comprises of companies that focus on engineering
technologies, sales and distribution of automobiles. A listed conglomerate
company in Nigeria is a company which is quoted on Nigeria Stock Exchange for
the purpose of trading on a regular basis by the investing public. The study
considered conglomerates because researches revealed that large-scale multifaceted earnings management is mostly associated with conglomerates owing to
their peciliar structure (Mehta & Srivastavaare, 2009 and Shehu & Jibril, 2012).
Also, in emerging markets the conglomerates are considered the main cause of the
employment growth rate and economic growth creation.
Existing literature on board supervision and the informativeness of firm‟s
earnings is based mainly on the US and European data and therefore, reflects
corporate behavior purely within these markets. Thus, very little is known about
the relationship between board supervision and earnings quality, particularly in the
smaller markets outside of the U.S., Europe, and certain emerging economies like
Nigeria (Ali, Saleh, & Hassan, 2008). In Nigeria, board supervision and earnings
quality study seems to have ignored the Impact of Board supervision on Earnings
Quality of Listed Conglomerate firms in Nigeria. The archival literature in the
area of earnings quality largely focused on firm-specific characteristics, such as
firm size and board independence (Dechow and Dichev 2002; Klein 2002,
Demerjian, Lev, Lewis, & McVay, 2013) and Number of meetings held by the
board members during the periods. Numerous studies in Western settings have
suggested that both firm performance and the informativeness of reported earnings
are affected by such BOD attributes (Yermack, 2004; Bédard, Chtourou, &
Courteau, 2004; Vafeas, 2005; Srinivasan, 2005). The study focused on this
attributes as proxies for board supervision. Accordingly, this study examines the
impact of board supervision on earnings quality of listed conglomerate firms in
Nigeria with a view to determine how these board attributes such as board size,
proportion of non-executive directors and number of board meetings have
significant impact on earnings quality of listed conglomerate firms in Nigeria.
This study uses accruals quality, which refers to the extent to which accruals
shift or adjust the recognition of cash flows over time so that the adjusted number
(earnings) measures firm performance and predicts future earnings and cash flows.
This is consistent with previous studies on earnings quality (Van Tendeloo &
Vanstraelen, 2005; Chen, et al., 2007; Barth, Landsman, & Lang, 2008)), which
often use the term „earning quality‟ to denote the absence of earnings management,
or the absence of income-increasing accrual. We select this measure because we
expect that better board supervisions are able to report accruals that more closely
correspond to the underlying economic activity, we expect the earnings quality
metrics that are affected by judgments and accrual estimation to vary with board
supervision.
1.2 Statement of the Problem
In Nigeria, board supervision and earnings quality study seems to have
received very little attention despite a good number of studies on corporate
governance and the conglomerate firms particularly after the Nigeria Security and
Exchange Commission released its code of corporate governance in 2003. One
reason for this inference is the lack of available data and poor access to appropriate
databases.
Corporate scandals that occurred world-wide have raised questions about
earnings quality and supervisory role of the board of directors. Many researchers
are of the view that these corporate failures were caused by inadequate corporate
governance, which included lack of oversight from the board of directors (board
supervision) and poor strategic decisions (from board meetings) (Li 2009;
Hamilton & Micklewait 2006; Grant & Visconti 2006; Garcia, Osma & Noguer
2007). The majority of these studies have relied on data of listed companies from
the US, the UK and to a limited extent, Europe. Despite the importance and
empirical findings of these studies it is questionable whether these results can be
generalised to other time periods and countries, due to different accounting
standards and variation in board oversight requirements at the time.
More so, in Shehu & Jibrin (2012), it is revealed that large-scale multifaceted low earnings quality is mostly associated with conglomerates firms owing
to their peculiar structure (e.g. transfer of profitable or toxic assets to/from the
subsidiaries, related party transactions, and so on). This, thus, makes it necessary to
investigate the implication and impact of Board Supervision on earnings quality of
listed conglomerate firms. This is necessary to avoid its micro and macro effects in
form of wrong investment and finance decisions, illiquidity problems and
corporate failures.
To the best of our knowledge, we are not aware if board size, percentage of
Non-executive Directors and Board meetings, all as a mechanism of board
supervision, has significant impact on Earnings Quality of Listed Conglomerate
Firms in Nigeria. The study is conducted to know whether the same result can be
obtained as with other previous studies using different sector (conglomerate firms)
and different time frame. This study therefore, is a modest effort to fill this gap.
1.3 Research Questions
The following research questions are answered empirically;
i. To what extent does Board Size has significant Impact on Earnings
Quality of Listed Conglomerate Firms in Nigeria?
ii. To what extent does the proportion of Nonexecutive Directors has
significant Impact on Earnings Quality of Listed Conglomerate Firms in
Nigeria?
iii. To what extent does the number of Board meetings has significant impact
on Earnings Quality of Listed Conglomerate Firms in Nigeria?